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  • Writer's pictureMarco Annunziata

Fast And Slow Threats To Corporate Profit Margins

The trends that shape our economic and financial environment are moving faster: technological innovation has accelerated; industries get disrupted at a faster pace; news spread more quickly and financial markets respond faster, with greater reliance on algorithm-driven trades.

Yet traditional economic dynamics appear to have gotten slower. Inflation ignored the tightening of labor markets for a long time; the boost of innovation can’t seem to wake productivity growth from its long slumber; and global growth powers ahead undeterred from the surge in protectionism.

Fast-paced action excites, and attention spans have shortened; we tend to underestimate slower-moving trends. We shouldn’t. As Daniel Kahneman teaches us, there is a time for thinking fast, and a time for thinking slow. Slow thinking and slow trends can be powerful.

The rise in inflation is a case in point. For a prolonged period, US consumer inflation failed to react to the decline in unemployment. Experts argued that the traditional relationship between unemployment and inflation no longer held—that the Phillips curve had flattened or even broken down. (The Phillips curve describes an inverse relationship between wages/prices and unemployment). Well, inflation has been rising for a full year now, from 1.6% in June 2017 to 2.8% last month. Core inflation, which excludes volatile energy and food prices, rose from 1.7% to 2.2%. Looks like the Phillips curve was not dead, but just sleeping.

Wage growth has been weaker and inflation has started to erode purchasing power. This will not last. With unemployment at record low levels, we should expect wage pressures to pick up—eating into firms’ profit margins.

The escalation in trade tensions has done little damage so far. But the damage will come. The first round of U.S. tariffs, on steel and aluminum, triggered loud outrage, but it was relatively limited in scope. We now face the risk of significantly broader tariffs between the US, China, and Europe. As the tariffs kick in, they will exert a drag on growth. Companies will face an additional headwind to profitability.

Global growth seems unlikely to get stronger; and the Fed appears determined to keep tightening liquidity. If protectionism and labor costs start eating into profit margins, stock markets will suffer.

The only tailwind could come from another slow-burning force: an acceleration in productivity growth thanks to the ongoing push in industrial innovation. But that has been the slowest engine so far. OECD research shows that new technologies are not spreading across companies as fast as they used to—in fact, they seem to remain limited to a narrow set of successful companies. I believe this is in part because deploying disruptive innovation is difficult—you need different processes, management practices, workforce skills. Trade barriers will make it even harder to diffuse new technologies across industries.

Innovation remains the strongest hope; but companies have a lot of work ahead to keep stock markets from getting gloomier.

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